How retail investors make investment decisions

Published at Sep 25, 2019, in Investor 101

Julia Maguire, Lelde Smits and Ky Chow of the Capital Network present “How Retail Investors Make Investment Decisions” to highlight how to understand this increasingly important category of investor. The video introduces "Block Theory" which is the process to make investment decisions. As the retail investor investment decision-making process differs from the institutional investor process it is important to understand how to effectively communicate to them.

Let’s start with a simple question - what is a retail investor?

A retail investor is an individual who buys shares for their own personal account, rather than for an organisation.

Typically retail investors are buying or trading in much smaller amounts than sophisticated or institutional investors. As a result of the personal and smaller nature of the investments, the decision-making process of retail investors can differ significantly from that of professional investors.

In Australia, compulsory superannuation regulation means that every single worker in this country is effectively an investor. At present, SMSF or 'self managed super' occupies the largest portion of Australia’s $2.65 trillion superannuation pool. About $782 billion, or 30% of super, is currently invested by retail investors that manage their own funds.

And, as the number and influence of retail investors in the Australian share market continues to grow, an increasing number of listed companies are seeking more effective ways of communicating with this increasingly important audience.

To help companies understand how to communicate more effectively with retail investors, we’re going to outline how retail investors make investment decisions – something we refer to this as ‘Block theory’. When talking about retail investors we mean all investors acting in a non-professional capacity. From ‘mums and dads’, to stock brokers and even fund managers investing their own money. We believe Block Theory accurately describes the process we all utilise to make investment decisions.

As we all know, investing in listed companies involves significant uncertainty. This is true for all investors, but non-professional investors face greater uncertainty due to having less time and resources to research investment opportunities. The significant uncertainty prevents many investors from acting. Therefore, investors must build confidence through education before they are able to act.

Building confidence involves accumulating pieces of information, or ‘blocks’. These ‘confidence blocks’ take various forms – from the simple mention of a company by a friend, to a detailed broker research report. The accumulation of blocks allows the investors to build up to their ‘confidence threshold’.

Once the investor crosses their confidence threshold, while uncertainty is still there, it now has been reduced enough that the investor can act. Research suggests that, on average, six pieces of information are required for an investor to make a decision.

The retail investor investment decision-making process differs from the institutional investor process right from the start. Firstly, retail investors don’t begin ‘at the beginning’, nor do they often grasp the full range of alternatives available. This is for many reasons, but largely due to the sheer number of options available to them.

Let’s take the example of the purchase of a new car. In Australia, there are more than 1,000 new car types to choose from. And of course, nobody begins the new car buying process by considering them all. Rather, we subconsciously reduce the size under consideration down to a manageable number, perhaps 6-10. We do this by eliminating most of the options.

To actively consider a smaller, more manageable number of options we begin a different process. Having identified the key features we want, we compare these to the features of the remaining cars. We eliminate cars if they do not possess all, or enough, of these features, which eventually leaves us with one car and a purchase decision we make with significant confidence.

So, how should executives and companies communicate and connect to retail investors? How do we arrive at a manageable number of companies to consider, and how do we progress from there to actually making an investment decision?

Block Theory describes the progress through which an investor progresses toward making an investment decision. It’s not one piece of information on its own that enables us to make an investment decision, rather the impact of many pieces, or ‘blocks’, that give us the confidence to invest.

Block theory has three stages: Stage 1: Entering the consciousness, Stage 2: Confidence building and Stage 3: Crossing the confidence threshold.

Next week, we will look at part two of this video series: ‘Communicating and connecting to retail investors’.

Disclaimer: The information in this presentation has been sourced from Listcorp as a general guide only and cannot be relied upon as legal advice.

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